2014 – 4th Quarter Letter – The Energy Loop
January 15, 2015
The S&P posted a killer 13.69% this year, the best for large caps both home and abroad. Our 9.71% custom equity composite bested the 8.95% P&A Blend and landed right on top of the 10.04% Dow. We find it unusual for diversification to lag like it did last year, but regression to the mean will resolve all disparities. Check out the attached reports for the actual performance generated by your accounts. At the end of 2013 we predicted high single digit returns from the equity markets. Like most prognostications, that might have been done with our fingers crossed since it was our desired outcome. In the end, we make our clients the most money when we keep them long term in their investments. Hopefully, our dearly departed… who got bucked off in the stress of 2009-11… have managed to re-introduce themselves to equities.
The Energy Price Cycle….
The big financial story of the year was expected to be Fed tightening and higher interest rates….it didn’t come close to happening. Rates went down instead of up and a decrease in the price of oil stole the show. West Texas Intermediate Crude (WTIC) fell from $107 per barrel in June to $53 at the end of the year, down 50%. This was a significant drop but not atypical, oil has fallen 50% in price five times since 1980, in each case retracing 50% of that drop in very short order. The last 10 years have seen corrections of -33.70%, -79.00%, -31.04%, -24.00% and -50.00%. Always finding its way back to around $110 per.
A little history might be of interest here. WTIC cost less than $10 from before the Civil War until about 1973…..pretty sure robber barons had a lot to do with that. In the early ‘60s the U.S. dollar became overvalued due to Johnson’s Great Society spending and the cost of the Viet Nam War (inflation). The Bretton Woods Agreement that pegged the dollar to gold was suspended by Nixon in 1971. Exchange rates were allowed to float and oil became denominated in the buyer and seller’s currency of choice (the dollar still prevails). Double digit inflation set in, the US backed Israel in the ’73 Yom Kipper War and Americans learned to spell OPEC and embargo.
Demand has dropped since 1973, as Americans have tried to divorce themselves from gas guzzlers and wasteful energy practices. If you Google the subject you will find that our energy usage has declined about 10% per capita since the mid ‘70s…..good, but not great. Supply has increased with the advent of fracking. The combined changes have allowed us to approach energy self-sufficiency. Once again, a good thing but not great when one considers the alternative energy possibilities.
Oil (energy) is a commodity, an exchangeable unit of economic wealth. As per this definition, one man’s barrel of oil is just as good as the next man’s barrel of oil. Since it is a commodity, price is subject to supply and demand. Supply and demand are in turn subject to economic, political and social pressures. If you mix in cartels, exchange rates and the hostile geography that oil lives in….you’ll get a better sense of all the pressures on the price of a barrel of oil. John D. Rockefeller wasn’t intimidated by any of these things, he created monopolies in drilling, transportation and distribution. Standard Oil was a force we will not see again, Rockefeller had enough clout in the oil patch to actually set international prices. It is very fair to assume that oil is still looking for an equilibrium price, where supply and demand become equal forces.
The price cycle in any market is subject to emotions, economics and politics. Stock market price cycles are longer and quite a bit less volatile than oil price cycles. Both move their respective assets from weak hands to strong hands. Let’s take a look at oil prices from a couple of different angles:
From an oilman’s point of view….
During peak oil prices:
Lots of drilling
Strong but decreasing demand with ample storage
Euphoria eventually yields to anxiety & denial
As prices drop:
Anxiety and denial give way to fear and panic
Strong producers idle Rigs while marginal types pump
Demand decreases while storage facilities begin to fill
Anxiety and denial give way to desperation and panic
At the bottom:
Desperation and panic create capitulation
Idled rigs approach record levels and marginal producers go out of business
Demand hits a low and storage facilities are full
Capitulation spawns despondency and depression
As prices begin to increase:
Depression is replaced by hope, relief and optimism
Rigs go back to work and margins improve
Low prices have stimulated the economy and demand is revived
Excitement and thrill lead back to euphoria
The denizens of the oil patch not only expect these things to happen, they expect them to happen with regularity. This price action is characterized by a “V” bottom as opposed to a stock market “U” bottom. A full price cycle in the stock market can take 5-7 years, the current bull market is evidence of that. The oil market commonly completes a full price cycle inside 24 months.
From a stock market point of view:
During peak oil prices:
Businesses and consumers have adjusted to high prices….discontent
The energy sector enjoys full employment
High oil prices act like a tax on the rest of the economy
Demand begins to drop as conservation practices improve
As prices drop:
Continued discontent, limited optimism
Improved production techniques have increased domestic supply, reducing dependence on marginal foreign sources
The marginal exporters (Russia, Venezuela, Nigeria, etc.) increase production and begin price competition.
Geo-political events can be counted on to exaggerate price action
The marginal foreign producers are poorly run countries…. expect a freefall or two in price
At the bottom:
Well run businesses become savvy while consumers become giddy
Lower energy prices act like lower taxes, consumers have more money to spend…. which they do.
Cheaper gas prices increase miles driven, flown and BTUs consumed. Demand increases.
Lower prices bring tough times to the marginal producers….think defaults and currencies collapsing
Banks experience decreased credit quality in their loan portfolios, becoming more risk averse
Margins increase for airlines, truckers, chemical companies, agriculture, miners, etc.
Businesses order replacement vehicles, add jobs and ignore alternative fuel projects.
Auto companies add production lines to their most popular models (pickups, SUVs & muscle cars)
As prices begin to increase:
Giddy consumers should become wary, but they are very slow to do so.
SUVs sell well, as do second homes and vacations….energy conservation, not so much.
Efficient producers begin to increase energy prices…..the consumer fails to notice.
Marginal producers begin to dot the landscape.
Is there any correlation here?
Very little. When you graph the price of WTIC against the S&P 500 you get wide divergences. The economic forces that influence these two markets are less than homogeneous. We think it is unlikely that the international oil producers are done venting their historical grief.
For over a century, oil prices were “pegged” (think fixed exchange rates). The oil was then “cracked” (refined) and used to produce a variety of petroleum based products. Those “petro products” were then sold back to our trade partners in transactions denominated at floating exchange rates….exporting the U.S. rate of inflation (double digit in the ‘70s and ‘80s.) The formula for these transactions was cost + margin + inflation = ill will. This practice lasted long enough to eliminate any and all trust between the Middle East and the United States.
In 1960 the Arabian states and few a other oil exporting countries created OPEC. In 1973 the pot boiled over and the first oil embargo occurred. Cartel and OPEC became household words. Spawned from greed, tribal politics and minimal human rights, this group was fairly quick to fall under its own weight. Not surprisingly, the haves of the bunch adopted the western world’s wasteful ways and the have nots became rightwing religious zelots. Today, OPEC has deteriorated from a cartel to a trade group and few of the members have each other’s back. The Saudis are indifferent to the Venezuelans, Iran is a rogue, Abu Dhabi is in a world of its own…..and so it goes.
Low oil prices are good for the U.S. consumer, but they come with a lot of baggage. The economic side effects are problematic and no one seems to be able to generate long term conservation reform. Like a lot of other things in life, fairness would be the best resolution. Our guess is we are in for another “V” bottom for oil prices. The current cycle, yo-yo or price loop could easily be resolved by early summer. The longer prices stay low, without damaging financial institutions…. the better for equity prices. Events like this scare the dickens out of regulators. As a result, interest rates will stay low for an extended period of time….again, all the better for equity prices. 2015 is going to be a good year. We’ll duplicate last year’s prediction and go with the same number for equities…..high single digit returns. Anything in the 7-9% range will look pretty good against fractional money market rates. We continue to “Like” stocks, favoring the unloved and gravitating toward dividend growers. The bull market won’t last forever but we have very little affection for bonds.
Tax time is coming up. At the current time your custodian is not required to mail your 1099’s by a specific date. Expect the 1099 composite as well the esoteric 1099’s in mid-February. Electronic delivery will be a little quicker. Master Limited Partnership K-1’s always test your patience, they are a function of the company’s tax year. Think late March at the earliest. Since 1099’s are subject to revision, you would be poorly advised to try and file early….take your time.
James S. Pittenger, Jr,